How the Chinese Government Created the Asset Bubble

There is little doubt that China faces a real estate bubble on the basis of conventional metrics. Price-to-rent and price-to-income ratios are both at the highest levels the world has ever seen. However, in the short-run, China’s repressive financial system and central bank backing keep the whole show going.

The real estate boom has been a driver of inequality and makes the country very vulnerable to its wealthiest elite.

Because of capital control, investors must pay a price to invest overseas, which compels them to invest domestically. Because both bank deposits and bonds have low to negative real yields and because of the volatility in China’s stock markets, Chinese investors have seen real estate as the best investment. Indeed, because most Chinese investors have felt the same way in the past decade, real estate has indeed yielded healthy returns to Chinese investors.

A number of households have earned spectacular returns on their extensive real estate investment. Meanwhile, the central bank has ensured the near linear rise in real estate prices by bailing out all financial institutions in China, large or small. This has prevented the kind of panic that pervaded Wall Street in 2008.

This investment model is not without costs or risks, however. The investment-driven growth, fueled in large part by the real estate boom, has distributed enormous amounts of wealth to a relatively small number of construction contractors and their friends in the government. This process has been a major driver of inequality in recent years.

In the mean time, ordinary households must pour an ever larger share of their savings and income into paying for their housing, which diminishes their ability to spend in other areas in relative terms. This is a reason that Chinese consumption as a share of gross domestic product is among the lowest in the world, despite high economic growth.

In the process of this wealth redistribution, risk is also building up. According to my estimate, the wealthiest 1 percent of urban households in China, roughly 6 million people in a country of 1.3 billion, now command wealth of between $2 trillion and $5 trillion.

If the real estate bubble bursts, these wealthy individuals may no longer see Chinese real estate as the best investment in the world. Even if this small handful of people move one-third of their assets overseas, China’s $2.85 trillion dollar foreign exchange reserve may be depleted by $1 trillion or more. The current growth model and the asset bubble can continue, but with each passing month, China becomes more vulnerable to its wealthiest elite.